This invention relates to a computerised method for valuing shares for use in identifying whether they are overvalued or undervalued, and to apparatus and programs for use in the method.
The valuation of entire businesses (known as “enterprise” or “entity” value) and groups of companies is an important tool in measuring the worth of their shares on the stockmarkets. It is also important in identifying whether current share prices are too high or too low.
Professional investors and investment advisors use computerised information systems to retrieve data and forecasts about individual companies. They also use computerised systems to value shares and groups of shares.
Background—Computerised Share Valuation &, Information Systems
There are many different types of system used by professional investors. However their aim is similar, namely to assist with the valuation of shares and the management of portfolios of shares. To do this they use a wide variety of data which helps them to predict the likely price of their investments in the future and to establish whether they should buy or sell the shares in a particular company (or corporation).
There are also a number of organisations that provide data to professional investors. These companies are known as “estimate” or “forecast” providers. Two well-known companies are First Call and I/B/E/S International (both now merged as part of the Thomson Financial group of companies), both of which collect from share analysts and brokers their forecasts relating to the future performance of companies. Other similar companies include Multex, Zacks and JCF.
Having collected broker forecasts these estimate providers then use computer systems to manipulate and present this data in a variety of ways. This is stored in databases which are then sold either directly to investment fund managers (along with the software needed to manipulate and extract the information) or indirectly through the systems of other information providers such as Factset and Reuters, who have their own manipulation and reporting software.
The use of computers is essential in modern investment. For example, I/B/E/S carries data for approximately 18,000 companies in 56 countries For each of these 18,000 companies they collect, store and manipulate numerous different forecast data items for up to 5 different years.
Share price indices also rely on computers; the Dow Jones and FTSE index are recalculated continuously. Investment fund managers and analysts regularly perform complex calculations on their own specific share portfolios, which could not be done without computerised valuation and management systems.
Background—Enterprise Value (EV)
In the investment community one valuation measure in common use is called Enterprise (or Entity) Value (EV). This measure represents the market value of the capital the company uses within the business. It consists of the following components.
The most important component is market capitalisation, which is the price an investor would need to pay in order to buy all the issued shares of the company at today's share price. Effectively this is the market value of the equity (or share) capital of the company, that is, the number of shares multiplied by the share price.
The second component is the value of the debt capital within the company. This is the long term borrowing of the company.
The third component is optional and represents adjustments to the first two components. Different people adjust Enterprise Value in different ways. For example, some make adjustments to cash, others to pension fund liabilities, and some for assets that are not key to the operational performance of the business.
The above can be summarised by the expression:EV=MC+VOD+ADJ where MC is market capitalisation, VOD is the value of debt, and ADJ represents any adjustments.
Whether or not adjustments are made, the rationale behind EV is however the same, namely to establish the market value of the capital employed within the entire company.
Background—Valuations Based on Enterprise Value
To aid the comparison of the values of different companies, EV is often expressed as part of a ratio, such as EV/Sales or EV/Cash-flow. The use of EV-based ratios enables one company to be compared with another. For example company A may have an EV of $1 million and company B may have an EV of $100 million. As such their performance and values are difficult to compare. But if the sales of company A are $500,000 and of company B are $10 million then the ratios of EV/Sales for these companies are 2:1 for company A and 10:1 for company B. In other words, for every dollar of capital invested in these organisations, company A generates 50 cents of sales but company B only generates 10 cents. So company A, although smaller, may be a better investment than company B. Looking at it another way, company A may be argued to be undervalued and company B may be overvalued.
Background—Discounted Cash Flow
For many years investors have realised that $1 received in one year's time is worth less than $1 received today. They recognise that money has a “time value” and that interest is earned to compensate for that time value. So $100 invested for one year at 10% interest may be worth $110 in one year's time. The interest rate is often expressed as the “cost of capital” invested. Another way of looking at this is that, at a cost of capital of 10%, the worth today of $110 received in one year's time is $100 ($110/1.1=$100). This $100 figure is known as the “present value” or PV of the $110 receipt in one year's time. We have “discounted” the future cash flow in order to arrive at this present value—hence the term discounted cash flow or DCF.
The PV of a sum received in period “n” is therefore defined as:
  PV  =                    earnings        /        cash            -              flows        ⁢                                  ⁢        in        ⁢                                  ⁢        period        ⁢                                  ⁢                  “          n          ”                                    (                  1          +                      interest            ⁢                                                  ⁢                          “              i              ”                                      )            n      where “i” is the interest rate expressed as a decimal, and “n” is a variable number of years in the future.
The method (also known as NPV or net present value) can apply to receipts in any particular year. So the present value of $121 received in 2 year's time is also $100 if we discount using a 10% cost of capital; that is $121/(1.1)2.
If moneys are received in more than one year the PV will be the sum of the receipts, suitably discounted. So the PV of $110 received at the end of year one and $121 received at the end of year two, using a 10% cost of capital will be $200; namely $110/1.1 plus $121/(1.1)2.
This DCF method has been used as one of the ways of valuing the shares of companies for many years. In this case the receipts are the stream of dividends paid by the company to its shareholders. This is known as the Dividend Discount Model (DDM). Variants of the model have also been developed to reflect growth in the dividend stream.
The DDM has also been modified to reflect the fact that some companies do not pay dividends. The amended models uses the earnings or cash generated by the company in each accounting period, instead of the dividends it pays. The rationale is that the company could pay these amounts as dividends but may choose not to in order to reinvest for the future.
The current theory of company valuation using DCF is summarised in Bartley J. Madden's book “CFROI Valuation” (Cash Flow Return On Investment) Butterworth-Heinemann Finance, 1999, ISBN 0 7506 3865 6. He states on page 9 that “the firm's warranted value is driven by a forecast net cash receipt (NCR) stream which is translated into a present value by use of the investor's discount rate”.
In theory the forecasts for the net cash receipt stream (also known as “free cash flow” or FCF) should continue to infinity. In practice such forecasts tend to be for a limited number of years so, in order to compensate for the lack of forecasts beyond the horizon, a “terminal value” (TV) is often substituted into the formula at time “n”, the date at which forecasts finish.
We have appreciated that the forecasts produced by estimate providers can be of direct use in the calculation of share valuations using the DCF or NPV method.
Background—Economic Profit and EVA
Stern Stewart a co, of New York, USA, have commercialised a particular version of economic profit which they have trademarked as EVA, economic value added. This is defined as earnings less a charge for the book value of capital invested at the beginning of each period. The charge is calculated using cost of capital and it is based on balance-sheet or accounting values, suitably adjusted in accordance with Stern Stewart's methods.
Adjustments that may be made include for example: capitalising research and development and long-term marketing expenses and depreciating them over future periods; adding acquired goodwill into the capital employed number (where this has not been followed in the normal accounting policies of the company); changing the method of depreciation; and capitalising leases and treating them as if the assets had been purchased and the money borrowed.
So, the initial adjusted balance-sheet value is used when measuring the EVA for period 1. However when measuring the EVA for period 2 a different figure is used.
Background—Residual Income (RI)
EVA is an example of a well-known technique called residual income valuation, which uses DCF methods but which also deducts an interest charge to cover the cost of capital from the earnings for each period considered. There are however problems with the existing RI techniques, some of which are described in a paper by James A. Ohlson “Residual Income Valuation: The Problems”, Stern School of Business, New York University, New York City, N.Y. 10012, USA; March 2000.
We have appreciated that one particular problem is that the existing RI techniques are optimised for corporate use and do not provide optimum results for an investor in the company. Furthermore, the existing commercial RI models necessitate complex adjustments.